Online Extra: Time To UnARM Yourself?

As rates climb and the housing market cools, it may be time to ditch your adjustable rate mortgage. Here's some help on whether to do so

April 11, 2005, 12:00 AM EDT

During the boom years, it seemed like a winning way to play the housing game. Take out a mortgage with a small down payment and a low adjustable rate. Buy as much house as you could afford, or maybe even a bit more. Then watch as rising housing prices turned a small investment into a big gain.

Certainly many Americans took this path in recent years, with 35% of all new mortgages in 2004 having adjustable rates. And why not? Going for an adjustable rate could mean paying just 3.5% -- and sometimes even less -- on your loan, well below a fixed-rate mortgage. For some that could mean the difference between being able to afford a home or being locked out of the market.

WEIGHING YOUR BEST MOVE.

This strategy seems foolproof -- until rates begin to rise, and the housing market cools. The Federal Reserve is not done pushing up interest rates. And every time it makes a move, the rates that adjustable-rate mortgages are pegged to generally head higher as well. As a result, that 3.5% adjustable loan could go up to 6.5% by next year, or even higher. Once-affordable payments can turn oppressive. Eventually, the home will start to seem more like an albatross than a nest egg.

One way to reduce your risks and avoid this problem is to refinance into a fixed-rate loan now, still at a relatively low 6.15%. Whether this move makes sense depends primarily on how long you plan to live in your home and how far interest rates are likely to rise from here.

One way to weigh your best move: Calculate how long it would take you to break even, should you switch to a 30-year fixed-rate loan at today's rates. Say a year ago you took out a mortgage with an interest rate of 3.5% that adjusts annually. If the loan is pegged to the one-year Treasury bill, its rate is likely to hit 5.5% this year, according to Greg McBride, senior financial analyst at Bankrate.com, a North Palm Beach (Fla.) consumer finance Web site. And if rates rise in line with market expectations, the rate could easily climb to 6.5% next year, McBride adds.

WHEN TO REFINANCE.

At that point, today's 6.15%, 30-year fixed rate starts to look good. But you'd be giving up the benefits of the 5.5% adjustable rate for the remainder of this year, and you'd have to stay in your home long enough to recoup the closing costs on a new fixed-rate mortgage. For a $300,000 loan, those costs could be about $5,000, although the actual amount will depend on your loan amount and location.

For someone with a $300,000 mortgage, the math goes like this: By sticking with an adjustable loan at 5.5% this year, you'd save about $124 in monthly payments, or about $1,488 this year, vs. a 30-year fixed loan at 6.15%. But when you consider that refinancing means paying about $5,000 in closing fees, the total cost of switching to a 30-year fixed loan climbs to $6,488. If rates hit 6.5% next year and stay at that level, though, a 30-year fixed-rate mortgage at 6.15% will start to save you money -- about $828 a year on a $300,000 loan, compared to a 6.5% adjustable-rate loan. In that case, it would take about eight years to come out ahead by refinancing into a 30-year fixed-rate loan.

The higher rates climb, the shorter the break-even point. But as a rule of thumb, if you plan on moving within five years, you're likely to be better off with your adjustable loan, says Paul Havemann, vice-president at HSH Associates, a publisher of loan information in Pompton Plains, N.J.

A HYBRID OPTION.

When searching for loans that offer a haven from rising rates, the 30-year fixed-rate loan isn't the only game in town. In fact, for those who want the security of a fixed-rate loan but plan to move within the next decade, so-called hybrid loans are a better deal. These come with fixed rates for the first several years -- you can get 3-, 5-, 7-, and 10-year plans. After that, the rates float. The benefit of these loans is that their initial fixed rates are below those on the 30-year fixed loan. A loan that locks in a fixed rate for five years, for example, will cost you 5.58% today.

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Homeowners who have taken out home-equity lines of credit need to be especially alert. Because the rates on these loans -- which allow you to borrow a set amount and draw on the cash as needed -- can readjust monthly, they're likely to head up from today's 5.91% rate on a $30,000 loan. So if you've got a sizable balance and aren't likely to pay it down soon, consider refinancing into a fixed-rate home-equity loan at 7.02%. That trades a little bit of extra payment today for some peace of mind tomorrow.